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Investing.com -- A less dovish Federal Reserve may not spell trouble for equities, and could even support further gains, according to Capital Economics.
In a report, senior markets economist James Reilly argued that “even if the Fed were to deliver less easing than the ~90bp currently priced into financial markets over the coming year, history suggests that wouldn’t prevent further strong gains from the US equity market.”
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Capital Economics noted that investors have recently lifted expectations for Fed cuts, helping improve sentiment.
But Reilly warned that “investors are still expecting an excessively dovish path for the fed funds rate over the next year,” adding that Treasury yields are likely to “rise again before long.”
Despite that, the firm said it expects equities to “see quite large gains - and outperform Treasuries - over the next year.”
The key, Capital Economics argued, is how markets historically behave when the Fed eases by less than investors anticipate.
Reilly highlighted that US equities have “performed better in periods when the Fed has underdelivered compared to when it has overdelivered,” with the S&P 500’s median real return at “~12.1%” in those phases.
The firm believes this likely reflects stronger-than-expected economic performance, which “more than offset” the impact of rising yields.
Capital Economics also noted that starting valuations have typically had little bearing on equity performance over the following year, leaving the firm “comfortable with our view that equities will fare well despite their already-high valuations.”
Reilly concluded that he doesn’t think “a hawkish Fed will undermine the relative returns from equities,” reiterating Capital Economics’ forecast for U.S. stocks to post “large” gains over the next year.